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10 Questions About Investing In Index Funds: An Interview With Mark Hebner

Mark T. Hebner is the author of Index Funds: The 12-Step Recovery Program for Active Investors and founder and president of Index Funds Advisors (www.ifa.com).

Why should investors choose index funds over actively managed funds?

HEBNER: I actually started off with the idea that active investing is really a little bit of a gambling addiction for investors, and therefore they should go through my 12-Step Recovery Program for active investors, which basically dismantles the whole idea of active investing and describes a more prudent passive investing strategy.

According to a study by Professors Barras, Scalliet, and Werners, 99.4% of 2,076 mutual fund managers displayed no evidence of genuine stock picking skill over a 32-year period from 1975 to 2006.

The remaining 0.6% who did outperform the index were “statistically indistinguishable from zero.” Or as Mark Hulbert put it, “just lucky.”

At the end of the day, one of the reasons you would pick an active manager is you believe he’s going to provide alpha—excess return for a fund relative to its appropriate benchmark.

What this study says is that it’s rare for managers to beat their benchmark every year.

What you discover is some years they do better; some years they do worse. On average, they may be positive but the more their returns vary, the more likely it’s due to chance.

If you don’t believe what I’m saying, carefully read the study. If you understand it, you will never again pay a fund manager 3 to 10 times what you pay for an index fund.

But fund managers seem to always be touting how they beat their benchmark. Are they misrepresenting their results?

One of the main reasons active managers appear to be beating a benchmark is because the wrong benchmark has been selected, number one.

Number two, they style drift throughout their history so that a more appropriate benchmark would be a moving benchmark, where one year might be closer to large growth and the next year closer to large value, and so on.

The missing link in all investment analysis is proper benchmarking.

What’s your evidence for that?

HEBNER: We did a study of 614 mutual funds over 10 years, and only 0.16% of them—basically one—had a return that beat what’s called a “multiple regression benchmark.”

Beyond these two studies, there are probably 100 different studies that come to similar conclusions in different ways. That’s why I would never pay a manager to actively manage my portfolio.

But what about investors like George Soros who appear to generate alpha consistently over time?

HEBNER: One second. Give me the standard deviation of the alpha; how volatile are his excess returns, his alpha? You slipped in the term that he “consistently” had alpha. I guarantee you that’s not the case.

In our study I just referred to, 80 of the 614 managers had positive alphas. The average alpha was 0.84%. The average standard deviation of the alpha was 5.64%.

With those two numbers, I calculated I would need 180 years of data before I could be 95% confident that the alpha they claimed was not actually zero.

One of the problems you have with managers like Soros is they close some funds. Not including the closed funds is called survivorship bias of the data.

How horrible were those funds? What happens is managers basically close down what turned out bad and leave open what turned out good.

Why isn’t there a possibility that the ones that turned out good weren’t due to just chance? The investment industry has had a horrible record in what I’ll call “a rigorous statistical analysis.”

What other reasons do you have for recommending index funds?

A risk-appropriate return is really what an index fund or a benchmark captures. The real questions for investors is, “How can I position my portfolio to have the best chance of actually capturing that return for the risk I took?”

There are three key elements for doing that. Number one is complete diversification of every investment that meets your criteria. So if want to invest in small caps, you want all small cap stocks in the entire world.

You want the 10,000 stocks that meet your definition of small because that minimizes the random errors in the pricing of those stocks. Prices are only best estimates, not the perfect price.

What’s the second element that will improve investors’ chances?

And the way we minimize those random errors even further is by holding for a risk-appropriate period—the second key element.

The longer you hold, the more you hold, and the more likely you’ll be appropriately paid for the risk you took.

And the third element?

Keep your costs and taxes at the absolute minimum. Portfolio turnover is part of those costs. I don’t want a manager trying to indentify which stocks are mispriced.

When there are 5,000,000 willing buyers and 5,000,000 willing sellers each day in the world, how in the heck does a manager know more than those 10,000,000 traders?

Could you explain in more detail how diversification will help investors capture risk-appropriate returns?

HEBNER: The expected return of an index is the same as every stock in that index, but the index has greater certainty of achieving that expected return.

Now, active managers would challenge this, but we have no idea which stock will generate which return in the future. That’s evident by the lack of stock-picking skill of those managers in the study, right?

What this means is, diversification is your buddy and the only free lunch in investing because you can buy that index at the same or lower cost than buying a stock and have the same expected return.

What attracted you to this subject in the first place?

HEBNER: A friend of mine was killed in a car wreck and left his widow a substantial amount of money. She said to me after being bounced around by various investment managers, “You’re a good businessman; you must understand investing. Help me translate what my investment manager is telling me.”

At that point I’d been 12 years with Morgan Stanley and really never understood what they were doing either. So I told her, “You know, I’ve always wanted to dig into this for my own portfolio, and you’ve given me the push I needed.”

I bought John Bogle’s books and Burton Malkiel’s books, among 20 others. And you know, what I’ve been telling you has been well known since the early 70s.

Anyway, I decided there was a real need to have a real quality education for investors to get them to do this right, so I wrote this book.

“10 Questions About Investing In Index Funds: An Interview With Mark Hebner” was written by Gregory Taggart.